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Accounting Basics

Accounting is often referred to as the language of business.  Accounting provides financial and nonfinancial information about a company’s operations, financial position and cash flows. Investors and other stakeholders look to financial statements and other financial reporting to make significant decisions on a daily basis.

Virtually every transaction or event that takes place in a company has an accounting impact. For example, a sales call to a potential customer.  Expenses, including the salespersons time, travel expenses, meals, product samples, must be accounted for and reflected in the company’s financial statements.  

Accounting is also often viewed as a “gatekeeper” over a company’s assets and resources.  This is an important responsibility that cannot be taken lightly.  Accountants are called upon to implement fundamental internal controls to safeguard company assets and ensure accuracy in a company’s books, records and financial reporting.   This section provides an overview of the basics of accounting. 

Objectives of Financial Reporting/Accounting 

In general, the information provided through financial reporting and accounting should be useful to readers, including being accurate, timely, understandable and have predictive value. Effective financial reporting provides users with information to make business decisions.  For example, a Chief Financial Officer of a large company may review cash flow information provided by his accounting department to plan capital expenditures for the coming year. The primary objectives of financial reporting are included in FASB Concept Statement No. 1, Objectives of Financial Reporting by Business Enterprises. The objectives are: 

·         Investment/credit decisions – information should be useful in making investment and credit decisions;

·         Assessing cash flow prospects – provide information on the amounts, timing, and uncertainty of future cash flows;

·         Company’s resources – financial reporting should provide information on the economic resources of a company and claims against such resources.  Information on how certain events or transactions impacted or will impact a company’s economic resources should also be provided;

·         Company obligations and stockholders’ equity – provide information on obligations owed by the company to third parties and make up of the company’s stockholders’ equity;

·         Performance and earnings – information on a company’s performance and earnings for accounting periods is essential to stakeholders.  Such amounts show the strengths and weaknesses of a company’s business and/or management;

·         Liquidity and solvency – stakeholders must be provided information on a company’s sources and uses of cash, including from operations, long-term debt or borrowing, capital contributions or other equity/owner related transactions, and significant claims against the company that may have liquidity issues;

·         Management stewardship and performance – financial reporting should provide stakeholders with a view on how a company’s management has performed in running the business and safeguarding its assets.  This objective keeps management accountable to stakeholders;

·         Interpretations and explanations – simply providing raw financial data is unacceptable.  Financial reporting must also provide narrative explanations and interpretations of the raw financial data, such as what key risk face the company, primary drivers of results and outlook on liquidity.  Interpretations and explanations are found in financial statement footnotes which are an integral part of the financial statements.     

Financial Statements 

Financial statements are the primary means of communicating financial information to stakeholders. The primary financial statements are: 

·         Income statement – the income statement shows a company’s performance (profit/loss) over a period of time (typically a month, quarter, year-to-date, or annual).  Revenues cost of goods sold, operating/administrative expenses, losses and gains are presented with the “bottom line” being net income. Also typically shown on the income statement are earnings per share which represents a measure of profitability on per share of stock basis.  You have probably heard of instances where a company’s stock price drops due it “missing its numbers.”  Such “numbers represent earnings per share and are found or calculated off of the income statement.          

·         Balance sheet – presents a company’s financial position at a point in time (for example, as of December 31, 20X1).  Assets, liabilities and stockholders equity are presented, with (remember the accounting equation) total assets equaling total liabilities plus stockholders equity.  Many of the performance ratios are calculated with reference to the balance sheet. 

·         Statement of stockholders’ equity – shows changes in stockholders equity during a period, such as net income, dividends paid, contributions and impact of the issuance of shares of stock.  The ending balance for total stockholders’ equity shown on this statement should tie to the total stockholders’ equity shown on balance sheet for the applicable period.

·         Statement of cash flows – shows changes in cash during a period.  Cash flows are separated and presented as either cash flows from (1) operating activities; (2) investing activities; or (3) financing activities.  In general, operating activities are those associated with the normal operations of the business.  Cash flows associated with investing activities are those used to invest in the business, such as capital expenditures.  Financing activities include proceeds from the issuance of debt or dividends paid.  Items on the cash flow statement should represent cash.  Significant noncash items should be disclosed in accompanying footnotes and not shown within the statement of cash flows.   

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